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What Is a 401(k)?

A 401(k) is the most popular employer-sponsored retirement plan. Find out how to use this tool to reach your retirement goals.

Written by Erin Gobler / July 5, 2022

Quick Bites

  • A 401(k) is a workplace retirement plan that allows individuals to save by having contributions automatically deducted from their paychecks.
  • 401(k) plans allow for either traditional or Roth contributions, each of which has different tax benefits.
  • The IRS allows workers to contribute up to $20,500 of their salaries to their 401(k) plan, and employers can also contribute on behalf of their employees.

A 401(k) is an employer-sponsored retirement plan that allows employees to save while taking advantage of certain tax advantages. The 401(k) plan is the most popular workplace retirement plan, and it’s how many Americans dip their toes into investing for the first time.

“401(k)s became popular in the 1980s as a way to encourage employees to save for retirement,” says Harry Turner, a former hedge fund manager and founder of The Sovereign Investor, a financial education website. “The name 401(k) comes from the section of the tax code that authorizes them.”

Inside this article

  1. How does a 401(k) work?
  2. Types of 401(k)s
  3. Contributing to a 401(k)
  4. Employer match
  5. 401(k) vs. IRA
  6. 401(k) penalties
  7. FAQ

How does a 401(k) work?

401(k) plans are offered by private-sector employers as a way to help workers save for retirement. When someone signs up for their workplace retirement plan, they can automatically defer a specific amount or percentage from each paycheck to their 401(k) plan. The funds grow tax-free until the employee needs them during retirement. These plans have other tax advantages as well, which we’ll discuss in the next section.[1]

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Once the employee has contributed funds to their 401(k), they can invest in a variety of options. Companies offer a menu of alternatives that typically include mutual funds and target-date funds, making it easy for workers to diversify their portfolios. Other investment options may include stocks, variable annuities among other things.[2]

Types of 401(k)s

Employees can generally choose between two different types of 401(k) contributions, depending on what their employer offers. Both options come with serious tax advantages, but each may be better for certain situations and workers.

Traditional 401(k)

A traditional 401(k) allows for pre-tax contributions, meaning they’re deducted from your paycheck before taxes, reducing taxable income for the year. Once the money is in the account, it grows tax-deferred in the investments. Workers will pay income taxes on the money when they withdraw it during retirement.

Roth 401(k)

A Roth 401(k) allows a worker to contribute to the plan with after-tax money. As a result, it doesn’t reduce their taxable income in the current year. Once the money is in the plan, it grows tax-free forever. And during retirement, the worker can take tax-free distributions since they’ve already paid taxes on the money.

“When your savings horizon is long, allowing for more time for compounding earnings to grow your account balance, or you believe you are in a lower tax bracket today than you will be when taking distributions in the future, saving in Roth vehicles can save you significant taxes,” says Amy Ouellette, vice president of product at Vestwell, a savings and investment platform.

Traditional 401(k) vs. Roth 401(k): Which is better?

When it comes to choosing between a traditional and a Roth 401(k), one isn’t necessarily better than the other. Instead, it will depend on your financial situation.

A traditional 401(k) allows you to reduce your taxable income and pay less in taxes now. You’ll be responsible for those taxes when you take your funds out upon retirement. This option may be best for those who believe they’ll be in a lower tax bracket during retirement. Because their tax bracket today is higher, taking advantage of the deduction now is more important.

A Roth 401(k), on the other hand, might be better for someone who believes they’ll be in a higher tax bracket during retirement. They want to pay the income taxes today while their tax rate is low so they can save later. These contributions are especially popular with young workers who are early in their careers and in a relatively low tax bracket.[3]

And remember, you don’t necessarily have to choose one or the other. Most companies that offer both traditional and Roth contributions allow workers to divide their contributions, putting a portion into a traditional 401(k) and a portion into a Roth 401(k).

“A hybrid approach may work best,” Ouellette says. “When you save with both pre-tax (traditional) and Roth contributions, you may have more flexibility in the future to determine the right distribution mix each year to meet your spending needs and desires.”

Contributing to a 401(k)

When you contribute to a 401(k), your employer usually takes the money directly from your paycheck and deposits them into your 401(k) account.

In 2022, the IRS allows each employee to contribute up to $20,500 to their 401(k) plan, up from $19,500 the previous year. For workers 50 and older, the IRS allows an additional catch-up contribution of $6,500 per year.[4]

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There’s also a combined contribution limit that applies to both an employee’s contributions and the employer match (which we’ll talk about more in the next section). In 2022, the combined contribution limit is $61,000 for most workers and $67,500 for workers allowed a catch-up contribution.

Employer match

In addition to the money you contribute to your 401(k) plan, many employers also contribute to their workers’ accounts in the form of matching contributions. When an employer offers a matching contribution, they agree to match up to a certain percentage of your salary.

“For example, if your employer matches 50% of your contributions, then for every dollar you contribute, your employer will also contribute 50 cents,” Turner says.

The matching contribution is different at each employer, but according to a 2021 study from Vanguard, the most common arrangement is a company agreeing to match 50% of a worker’s contributions, up to 6% of their salary.[5]

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“This is an excellent way to save for retirement because not only are you contributing money tax-free, but you're also getting free money from your employer,” Turner says.

Of course, employers don’t have to match their workers’ contributions. On the other hand, some companies contribute to their employees’ 401(k) accounts regardless of whether the employee themselves contributes.

401(k) vs. IRA

A 401(k) is the most popular tax-advantage retirement plan, but it’s not the only one. Another popular option is the individual retirement account (IRA), which allows workers to invest for retirement on their own outside of an employer-sponsored plan.

The benefit of an IRA is that anyone with earned income can open and contribute to one, regardless of whether their employer offers a plan. The IRS allows workers to contribute up to $6,000 per year or 100% of their earned income, whichever is lower. There’s also a catch-up contribution of $1,000 allowed for workers 50 and older.[6]

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Just like the 401(k), there are two types of IRAs: traditional and Roth. With a traditional IRA, workers can deduct their contributions, have their investments grow tax-deferred and then pay income taxes on their withdrawals. And with a Roth IRA, workers contribute with after-tax earnings but then never pay income taxes on those dollars again.

Note: The IRS places income limits on who can contribute to a Roth IRA. if you’re a single person earning more than $144,000 or a married person earning more than $214,000, you won’t be able to contribute to a Roth IRA.[7]

401(k) penalties

If you’re contributing to a 401(k), it’s important to understand the penalties you could be subject to.

Because these plans have a specific purpose—retirement, the IRS requires that the money remains in the account until a worker reaches age 59½. If you withdraw it early, you’ll be subject to a 10% penalty, in addition to any other taxes you owe.

Note: There are a handful of other exceptions that could allow someone to withdraw from their 401(k) early, including facing financial hardship or taking a loan from the plan.[8]

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Another penalty you could face is for failing to take your required minimum distributions. The IRS requires that everyone start withdrawing from their 401(k) accounts by the time they reach 72. If you fail to do so, you’ll be stuck with a penalty of 50% of the amount you failed to withdraw.[9]

FAQ

What happens to my 401(k) if I quit my job?

When you leave your job, you’ll have a few options as to what to do with your 401(k). You can leave it with your former employer, roll it over to a 401(k) with your new employer, roll it over into an IRA or cash it out entirely.

How do I make money from my 401(k)?

You make money from your 401(k) with the investments you purchase. Most 401(k)s offer a variety of mutual funds and target-date funds, which can help you grow your contributions over the years.

Which is better, a 401(k) or an IRA?

There’s not necessarily one that’s better. Many people like the flexibility of an IRA, but 401(k)s have considerably higher contribution limits and offer the benefit of a matching contribution from your employer.

Is a 401(k) worth it?

Yes, a 401(k) is definitely worth it. Social Security isn’t substantial enough to be the only source of income during retirement, and saving alone isn’t enough. A 401(k) allows you to invest your money for faster growth while taking advantage of tax benefits.

Article Sources
  1. “401(k) Plan Overview.” IRS. https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview.
  2. “Investing in Your 401(k).” FINRA. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/investing-your-401k.
  3. “Roth vs. Traditional 401(k) — Which is Better?” Charles Schwab. https://www.schwab.com/learn/story/roth-vs-traditional-401k-which-is-better.
  4. “Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
  5. “How America Saves 2021.” Vanguard. https://institutional.vanguard.com/content/dam/inst/vanguard-has/insights-pdfs/21_CIR_HAS21_HAS_FSreport.pdf.
  6. “Retirement Topics — IRA Contribution Limits.” IRS. ​​https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
  7. “Amount of Roth IRA Contributions That You Can Make for 2022.” IRS. ​​https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022.
  8. “Hardships, Early Withdrawals and Loans.” IRS. https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans.
  9. “Retirement Topics — Required Minimum Distributions (RMDs).” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds.

About the Author

Erin Gobler

Erin Gobler

Erin is a personal finance expert and journalist who has been writing online for nearly a decade. Erin’s work has appeared in major financial publications, including Fox Business, Time, Credit Karma, and more.

Full bio

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